Spain's Budget--Details Tomorrow

The details Spain's 2012 budget will be available tomorrow when it is presented to parliament. The government enjoys a large majority in parliament and there is no doubt that the budget will be approved. The importance for investors lies in the details that will provided to the broad stroke presentation made at the end of last week.

Prime Minister Rajoy is just past 100 days in office and there has not been much of a honeymoon. Shortly after taking office, Rajoy offered a 15 bln euro austerity package. Spanish bonds have under-performed especially since March 2 when Rajoy unilaterally raised this year's budget target from 4.4%. The EU allowed some fiscal back sliding, but not as much as Rajoy wanted. Recall Rajoy said a 5.8% deficit/GDP was reasonable this year. The compromise with the EU was for a 5.3% shortfall. Ultimately, Rajoy might be right and 5.8% is more reasonable (as in likely) than the new EU approved target.

The broad outlines of this year's budget includes almost 18 bln euros in spending cuts (ministries on average will see a 17% cut in expenditures) about a 10 bln euro increase in taxes (largely corporate taxes, but a separate decision by the Supreme Court results in a 7% increase in consumer electricity prices and a 5% rise in natural gas prices).

There was no cut in civil service pensions. Nor was the VAT hiked, even though Spain's 11% VAT is among the lowest in the euro zone. Note that those advocating policies that could mimic a devaluation include a VAT hike to discourage purchases of imported consumer goods and a cut in payroll taxes.

To reduce the deficit from 8.5% last year to 5.3% this year is a Herculean task. Even if this is achieved, which we are skeptical of, more austerity will be needed next year to bring the deficit to 3%, which Rajoy says he is committed to. And some of what he proposes this year are one-off measures that will have to be replaced next year, such as the tax amnesty, which the government hopes will raise 2.5 bln euros (~10% of the 25 bln euros that is thought to have evade taxes). If a fiscal overshoot is evident later this year, pressure will mount for more austerity measures this year.

There are some questionable assumptions in the budget as well. For example, it assumes that the social security system (which includes unemployment benefits) shifts from a deficit to equilibrium this year even though unemployment rate is poised to continued to rise.

Rajoy's support appears fragile. Not only did his PP party fail to secure a majority in Andalusia recently, but its came in third place in another regional election (Asturias). And it is the autonomous regions that also are key to Spain's fiscal performance. Their figures were not included in the budget presentation last week.

There are several questions that investors have about Spain's budget. The first is whether it is credible. Is it reasonable to expect it to reduce its deficit by an unprecedented amount amid an economic contraction, falling land and house prices, rising non-performing loans at the banks, and high and rising unemployment? The second is will the denominator of the deficit/GDP fall faster than Spain can reduce the numerator? Today's manufacturing PMI showed an acceleration of the economy's slide. The 44.5 reading in March compares with 45 in February. The service sector PMI is released mid-week and is expected to fall to 42. Third, can the deficits of the autonomous regions be brought under control?

Banks, households and the government sector are all engaged in deleveraging. It is difficult to see where aggregate demand will come from. Spanish exports in January were up about 4% from a year ago, but the pace appears to be leveling off.

Spain's stock market is the worst performing in the euro zone thus far this year, losing 6.1% and 10-year bond is the worst performing bond in the euro zone thus far as well. The risk is downside on growth and upside on the deficit.